A mere ten years ago the Latin American airline industry was nearly extinct. The healthiest specimen was Lanchile (NYSE:LFL) and the biggest survivor was Varig, though scarcely in good condition. The years have ticked by and 9/11 and the oil price surge have done their work of leveling the playing field. In the preceding years a series of ill-thought out and executed privatizations had delivered many of the State-run airlines into the loving hands of Iberia, the Spanish carrier that proceeded to gut them and integrate them into its own structure to expedite transfer pricing.
Via this process a string of names were rendered bankrupt or scarcely operable. The US airlines moved in with proliferating networks across the region. These channeled flights to the US and particularly through Miami. The local travelers were glad of the chance to use these airlines as the service was better than anything offered by Iberia-controlled groups and many Latins also had relatively unobstructed access to US via visa waiver programs. This in particular pertained to the Argentines who were flush with cash under the Convertibility regime that lasted the whole decade. Most of the flow was northbound with Latins heading to the US to spend their pesos and reales in US malls. Latin America hadn’t shaken off its tawdry political image and the countries down there were just not dirt cheap compared with other locations.
Since 2000 the equation has changed. It was the US airlines that stalled as 9/11, the Argentine economic collapse and the surging price of oil removed clientele and sent operating costs soaring. Pricing power was weakened just as costs needed to be passed on. Draconian visa rule changes in the US resulted in a plunge in visitors from Latin America. The US airlines retreated on mass hacking back the number of flights and reducing destination options. The quality of service dived. Europe became more problematical as a travel destination as the dollar dived taking Latin “dollar-linked” currencies down with it.
Correspondingly in recent years, travel into the region has taken off, particularly from the US and Europe. Argentina currently sees around 250,000 US visitors per annum largely attracted by the cheap and trendy image that has evolved since the 2001 economic slump. This has provided spinoffs for Chile, where the currency is not down and out by any means, but where tourism options are comparatively inexpensive all the same. Brazil is more problematical with the bad press on crime and tourist assaults being virtually unchanged from the 1990s and 1980s.
From 2004 though a new world evolved. The retreating US airlines ceased to shade the growth of a new breed of resurgent local carriers. It is hard to pin down exactly what had changed the management dynamics. Unlike other industries in the region it wasn’t an infusion of “outside” talent that helped Lan be the first airline to make a break for international recognition. After all, brining US airline executives to run a Latin airline would scarcely be an improvement considering how poorly managed US airlines were. Maybe it was more a case of learning “how not to do it”. Lan gradually started getting its own house in order in the 1990s. It cloned itself into some neighbouring markets in a small way as part of the climb up the learning curve. This worked and Lan became the gold standard for users (and investors) amongst Latin airlines.
The way forward
It is interesting to speculate on the future of air travel in the region. Air traffic across all of Latin America grew 5% in 2006, the U.S. Federal Aviation Administration. While not stellar this growth is firm and we suspect it is less potentially subject to wild fluctuations as air travel numbers are in the US. There is no reason for it to decrease beyond the economic/political wobbles that periodically affect one or the other country. The US airlines still seem relatively clueless in the region. This seems a microcosm of the problems the US has in general in Latin America. So Lan should cement its grip on Chile and the West Coast of Latam. Gol (NYSE:GOL) with its purchase of NovoVarig will dominate Brazil’s external flights, Aerolineas if it keeps on its current path will at least remain dominant on the US and Australasian routes it flies, Copa (NYSE:CPA) will blitz Central America and the slowly recovering Avianca should give American a run for its money into Colombia.
European routes are much more balanced in the competitive advantage against the local carriers, mainly because the Europeans didn’t ceded as much territory in the tough times as the Americans did.
We would not be surprised to see within five years that there might be two world-class carriers based out of the region. This could transform the route patterns seen thus far. For instance Aerolineas’ flight to New Zealand and Lan’s to Tahiti are the only links to Oceania. There are minimal links to Asia, except for a route from Sao Paulo to Tokyo (via LA). The main African connection is Malaysian Air’s route via Cape Town from Buenos Aires and Varig flies to Lagos in Nigeria and Luanda in Angola. The only flight, to our knowledge, from Latin America to the Middle East is provided by Iran Air! These situations could be remedied. The second revolution could be cheaper internal flights. This age has dawned in Brazil and there have been some attempts in Argentine (where cheap has become confused with unsafe). Inter-regional travel is still a big expense. Sometimes it is cheaper to commute between Sao Paulo and Santiago or Buenos Aires than to fly from the same places to Miami. This situation may or may not be corrected by market forces. Governments in the region have done little to demand cheaper fares throughout the region, as they seem to fear their own citizens’ spending money at neighbouring countries’ resorts. They also seem to like the idea of having foreign tourists coming on trips exclusively to one country and not doing a “circuit”.
Our economic outlook at the moment is strongly oriented towards peak oil considerations. This spells ever-higher oil costs going forward. Maybe an age might dawn will air travel may be expensive again like the 1950s and 1960s. It is not clear that further cost savings via technology are all that possible. Nationalist issues can also be a consideration. Lan was trumped by local talent for Varig, despite having positioned itself early. It also ran into problems in Peru a while ago. It probably would have ended up with Aerolineas if nationalist matters were not a fear for management. There must also be some hidden agenda in Colombia that Avianca didn’t attract more interest form the local up and coming airlines in the region. Instead it was sold to the Coffee Growers Federation (amongst others).
Then there is the consideration of a slower US economy as our model is predicting. As most of the new players, except Copa, are not strongly dependent on flights to the US, this is only a mild concern. If anything another bout of weakness for US airlines might have them cede even more space to the newer players. Though we might also note that Southwest and JetBlue might eventually start intruding into the region with their discounting ways. This should hit US carriers first, in any case.
Traffic Controller and Airports – outside interference?
There is still a ways to go in bringing standards in airports and traffic control up to international standards. Doubts have long existed also about security issues.
In Brazil, flight delays and cancellations increased after a Gol aircraft and a business jet collided in mid-air in September of last year, killing all 154 people aboard the Gol Boeing 737-800 and creating an international scandal involving the US-piloted Embraer jet that was also involved. The Gol incident last year was a particularly damning indictment of the way in which “no fault” management reigns, particularly in those countries (i.e. most) in the region that have air traffic control and many other aeronautical functions vested in the national Air Forces.
This is best illustrated in Brazil where the airports are spiraling into chaos. Closures at Congonhas in Sao Paulo, which shut 18 times in the first quarter, are an ongoing problem. Growth in domestic air travel of 49% in the last five years has overstretched ground control and landing strips, causing delays and cancellations. In 2007 thus far only 70% of Brazilian flights have been on schedule compared with 90% in 2006, according to Infraero, (the country's civil aviation regulator that also owns and operates all of Brazil's commercial airports). Bloomberg reported that on April 24, Brazil's Senate planned to investigate the delays. The Lower House plans a similar probe. Last year, Congonhas, which was built in the 1930s and is now the country's busiest airport, handled 18.5 million passengers, about 50% more than its official capacity, according to Infraero statistics.
After the Gol crash, air traffic controllers instituted a work-to-rule slowdown, which reduced the amount of flights they monitor. Brazil has 2,800 controllers with a further 800 needed according to experts. The air force, which is responsible for air traffic safety, announced that it would hire 463 controllers by the end of 2007. Beyond controllers, there are problems with their resources, such as radio and other equipment to monitor air traffic that is also prone to breakdown after government budget cuts caused the Brazilian air force to reduce maintenance.
The airport at Brasilia has been closed twice since December because of radio-equipment failure, prompting a chain reaction of delays and cancellations at airports across the country. At Guarulhos, an airport near Sao Paulo that handles both domestic and international flights, landings were suspended for a number of hours on several days in March because equipment that helps aircraft land in fog wasn't working.
The Federal government plans to spend R$3 billion ($1.47 billion) by the end of 2010 to expand airport capacity by a third won't resolve delays and overcrowding because the money isn't destined for the places most in need, according to experts on the theme. Amongst urgent needs is a third runway at Guarulhos.
In Brasilia, where the government has recently built a second runway at the country's third-biggest airport, there aren't enough gates for the extra planes. Plans to expand airports in Florianopolis and Curitiba, in southern Brazil, and Natal and Fortaleza, in the northeast, don't match anticipated growth in traffic over the next seven years either.
These bottlenecks in Brazil force airlines to schedule flights at times and use airports that aren't the most convenient for passengers (or profitable for the airlines). The situation is a tad better in Argentina where many of the main airports were privatized in the late 1990s. Growth is a challenge for all airport and control administrations across the continent. Ultimately privatizations in the Argentine mould will be the way to go for government’s ever hungry for cash and ever slow to fund the investment required to remain state of the art in aeronautical matters.
The Airline Plays – current and prospective
We shall give an overview here of the currently quoted airlines (and one potential name) that will give an idea of the recent performance and their perspectives into the medium term.
Aerolineas Argentinas – Raised from the Dead
This is a name that conjures very mixed memories from the 1990s. The Argentine national flag-carrier was first broken up into Austral and Aerolineas then privatized, then recombined by owners oblivious to the initial conditions of the privatization. Then they ended up being controlled by Iberia. This rather mediocre European airline had nothing to teach the local carriers on any score and Iberia milked dry Aerolineas and other airlines it pounced upon across the continent. Eventually the whole structure came tumbling down and the airline ended up in the hands of the Spanish Marsans group (which owns Air Comet in Europe). Finally, the airline found an owner with more tender mercies and a better clue on what customers want.
It currently controls 80% of all domestic flights in Argentina and 40% of the international flights out of the Ezeiza airport. Aerolineas is now regarded by many Argentines as the airline of choice to travel to the US, where the service has plunged on American, and United and Delta retrenched. Those who like a cup of coffee after their “meal” chose Aerolineas, those who want to see a film made this century chose Aerolineas and those who want to drown their sorrows (or cover up the taste of the food) chose Aerolineas rather than paying $4 for a sip of firewater on American. Such is the transformation that the cheapest fares to the US are on Aerolineas, the frequent flier scheme is actually sought after and the most modern planes belong to the national line. It has often been proposed that a listing of Aerolineas in the Bolsa is imminent. However we have heard this for two years and nothing has yet transpired.
Copa Holdings (CPA)
Copa Holdings (CPA) is the parent company to two wholly owned subsidiaries, Copa Airlines and Aero Republica. Copa operates from its “Hub of the Americas” in Panama and currently offers 110 flights per day to 36 different destinations covering North, Central and South America as well as the Caribbean. Aero Republica is Colombia’s second largest domestic carrier covering 12 destinations inside the country and also connecting to the Panamanian hub. It also has an association with Continental Airlines (NYSE:CAL) via its “One Pass” scheme. It is also a major positive that places like Costa Rica and Panama are becoming bigger holiday destinations from the US and a serious option for a rising tide of retirees.
CPA has enjoyed rapid expansion in recent years. In 1991, before Copa’s hub operation began, it had 14 destinations and 66 city pairs. In 1992 its hub operation began. By 1995 it served 21 destinations with 220 city pairs. The company ended 2006 with 36 destinations and more than 1000 city pairs.
When we first recommended the stock in August 2006 (KWR Special Report: Thirsting For a Cuba Libre August 3 2006), the stock was trading in the $22 to $24 range. The near threefold increase in stock price is such a short time is very impressive, but we feel there is plenty more to come. The company is dedicated to improving the quality of service offered, with an on-time arrivals record of 91% (up from the impressive 90.3% average of 2006) showing their commitment is paying off.
EPS growth is equally eye-catching. The chart above illustrates EPS growth over the last four years and the breakdown inside FY06. The oil price spike in FY06 affected profits in 2q06, but the company soon got itself back on track and the $0.97 posted in the fourth quarter makes prospects going into 2007 look good. We would expect a PE for 2007 of less than 13X, right on the industry average mark. Coupled with continuing growth of over 25% this year, we reiterate our Long rating on CPA and would add on any short-term weakness in stock price
Lan Airlines S.A. (LFL)
Lan Airlines is based in Chile, but has expanded its reach over South America over the years. With a market cap of a little under $5bn it is the most established carrier in South America. It operates both passenger and cargo routes, with cargo making up approximately one third of the U$3.03Bn revenues in 2006.
Being a well-established entity, yearly revenues give a good idea as to the current health of the company. Since 2001, LFL has increased revenues from $1.7bn to $3.03Bn recorded last year. The company recently issued guidance for FY07, and expect revenues of around $3.6Bn in FY07, representing a growth rate of 18.9%.
LFL has seemingly been beaten to the gun in a recent attempt to buy Brazil’s Novo Varig airline. In January 2007 LFL made an initial move on Varig in the form of a $17.9m loan to the company. All industry watchers then expected LFL to make a formal bid for NovoVarig, but in March this year Brazilian airline GOL announced that they had snatched the prize from under LFL’s nose by paying a reported U$320m for Novo Varig.
Thus LFL remain without any meaningful presence in South America’s most important market. However the company clearly has intentions to expand via acquisition and we would expect them to be a little quicker off the mark with any further M&A activity.
The 19% growth rate would look good in most sectors; however LFL is being outstripped by its rivals at the moment. On the plus side, the 3.5% dividend yield makes long –term holding an attraction for managed funds.
GOL & TAM
Gol Linhas Areas Inteligentes S.A. (GOL) and TAM S.A (Transportes Aereas Meridional) (NYSE:TAM) are the two big Brazilian carriers currently fighting for market share in the rapidly growing Brazilian airline market. The two companies hold between them 95% of the Brazilian domestic flight market and are locked in a price war described as “brutal” by a leading Wall Street investment bank, which recently cropped their rating on both stocks due to an estimated 20% expected drop in revenues going forward. Whilst this may be true in the near term, we feel that investors would be shortsighted to walk away from this activity in Brazil and suggest the discerning investor to take a long term view of the Brazilian players.
Brazil's domestic air industry surged after GOL began service in 2001 as a discount airline, offering tickets 25% cheaper on average than competitors. Lower prices, along with steady economic growth, prompted air travel to expand more than 13% per annum since 2003, compared with the government's forecast of 8% a year.
The cut-price travel sector is a new concept in South America, as until today air travel within the continent has been regarded as expensive and demands a far greater percentage of average income than the no-frills services so widely available in Europe and the USA. Success stories such as Southwestern (NYSE:LUV) and Ryanair (NASDAQ:RYAAY) on both sides of the North Atlantic show the sector can be profitable, and we would point to the vast untapped market in Brazil and wider Latin America as fertile ground for such a business model.
As mentioned in passing in the LFL coverage, GOL has recently acquired Novo Varig, once the Brazilian state airline, paying $320m for the company to a clever consortium headed by US fund Matlin Patterson, who had previously paid just $24m for Varig and then brought them out of Chapter 11 bankruptcy protection. GOL will be looking to capitalize on the intercontinental routes held by Novo Varig.
With its new Novo Varig asset GOL has a market cap of $5.8bn, whilst TAM has a market cap of just under $4bn. Both are growing their fleets exponentially with TAM intending to add 31 planes to its fleet of 102 aircraft by 2010, and GOL, which has 85 aircraft, planning to add 67 more by the end of 2012.
GOL has had a frustrating 1q07. The positives of adding a new international route to Lima, Peru and another internal route have been offset by the drop in passenger occupancy blamed by all carriers on the current mistrust that passengers have with Brazilian air traffic control. GOL says it lost 230 million reales of revenue in the past two quarters because it was forced to increase discounts to attract passengers to its flights following the delays. The company also reported 71 million reales of additional expenses because its airplanes were in the air longer because of the air traffic controllers' slowdown. As a result, yields (revenue per passenger kilometer flown) will fall this year to 20 centavos from 23 centavos.
The 1q07 revenue drop was in line with Wall Street’s expectation, down 22% YoY. In their conference call on the 20th, the company also guided lower for the future quarters but were however extremely upbeat on prospects.
The lower guidance for the next two quarters is also partly a result of the integration of Varig, now a wholly owned subsidiary of GOL, into the company. Once things are running smoothly, the company expected to enjoy earnings growth that matches its current expansion in market share growth. They believe that current woes experienced from the Brazil ATC situation would soon be forgotten.
GOL is currently at $28.91, well off its 52-week high of $41.25. We like the Novo Varig Acquisition and, despite the ongoing price war with competitor TAM, it is an attractive play when compared to the more mature LFL.
The aforementioned TAM is also expected to suffer a similar drop in revenues in 1q07, but recently brought evidence to the market that consumer confidence is returning to the Brazilian air passenger. The company reported a record of 91,000 passengers carried in one day on April 9th, at the end of the Easter holiday period, a traditional peak time for travelers. As a result of the airport shambles, yields at TAM will fall this year to 25 centavos from 26 centavos per passenger kilometer flown.
TAM with 51.7% of domestic traffic, and holding 63% of international market share, is the market leader that GOL is seeking to topple. However, we feel that the price war will not cause either of these companies to suffer unduly. A duopoly such as the one enjoyed by TAM and GOL will eventually find its pricing level more quickly than a more open price war as in Europe (“cartel” may not be a term of Latin American-origin but they have perfected the art), and the prospect of mutually assured destruction will stop things from getting too out of hand.
Choosing – Going for Gol
Of the two, we would opt for GOL as the better investment option from here out. The Novo Varig purchase makes a lot of sense to their business model, and the company has shown more consistent growth than TAM. Saying that, it is a choice between “good” and “better” right now, the recent ruckus in the Brazilian airlines industry having opened a nice window of opportunity to value hunters.
Our final chart below shows the one-year comparative performance of all four stocks. CPA has outstripped them all, and we like the company going forward. LFL has done very nicely too. We would, however, pass them over to stick to our top pick of the four outlined, GOL.
There is much to like about this Brazilian carrier from here. The flat stock price performance of the last 12 months is due to external interference as much as the company’s shift in focus to the cut-price travel sector. With expansion via the Varig purchase, plus the six new jets scheduled to be delivered in December, the company is in the last stages of the repositioning process it embarked upon last year.
From the lone airline play of LanChile ten years ago now there is a fully-fledged airline sector for Latin investors to contemplate. Airlines, for anyone with experience of the US sector, can be a dodgy thing indeed. Successions of players in the US have gone bankrupt over recent decades. The problems they faced are not those that the Latin airlines might experience. US airlines were overblown in both structure and pay scales. Latin airlines do not suffer these problems. The collapses of the ex-State airlines in the region was largely a result of feather-bedded structures of the 1970-80s combined with obsolete fleets being finally dealt a deathblow by rapacious interloping “owners” like Iberia. The one common denominator though has been oil prices. Curiously though, results at Latin American airlines have been less affected by oil considerations than one might have thought.
The future for these carriers will be in expanded inter-regional services at lower fares. Why does it cost $1000 to fly from Lima to Buenos Aires when one can fly from Bs As to London for the same? AS routes expand and capacity fills up utilization rates will improve and more flight vectors will become viable and cheaper. We cannot see an appearance of more names in the region. Some battered names may expand their presence as their health improves (Avianca for example) but the main players are essentially evident on the field now.
Knowing Latin investment trends, it may not take a dramatic upturn in sales or even profitability to lift this sector to greater prominence amongst investors in the region. Maybe all it will take is a realization that there is more to the region that Petrobras, America Movil and some rather stodgy utilities.